11.12.2014 Clearing Up the Confusion Surrounding Stress Testing
When it comes to the expectations of the financial regulators with regard to loan portfolio stress testing, community bankers can be forgiven if they sometimes get a little confused. Dodd-Frank doesn’t require community banks with $10 billion or less in assets to stress test their portfolios, but regulators have made it clear that they think it would be a very good idea.
Fortunately, the OCC has provided some regulatory guidance to try to help clear up the confusion. The OCC published Community Bank Stress Testing: Supervisory Guidance (Bulletin OCC 2012-33) to help community banks determine the best way to use stress testing to spot and quantify portfolio risk.
What the Bulletin Says
In a nutshell, the bulletin states that some form of annual portfolio stress testing or sensitivity analysis is critical to sound risk management for any bank, including community banks smaller than $10 billion. And stress testing should be performed on the entire portfolio, not just on individual loans, according to the bulletin.
The regulators expect all banks, regardless of size, to have a plan in place for how they will maintain adequate capital levels, in addition to effective internal processes for assessing capital adequacy as it relates to overall risk. They believe that stress testing is the best way for community banks to find out where they’re vulnerable to market forces and determine how they will manage these risks.
This regulatory guidance goes beyond stress testing for interest rates to include stress testing for other adverse market factors that can affect commercial real estate (CRE) loans and acquisition, development and construction (ADC) loans. These factors could include falling rents, slowing absorption rates, rising cap rates, and higher operating expenses for property owners.
The OCC bulletin gives community banks some leeway in terms of deciding which of these and other market factors they should test for. “A community bank’s approach to stress testing should fit its unique loan portfolio strategy, size, loan types, composition, operations, and management,” it states.
Types of Stress Testing
While the bulletin doesn’t endorse any specific stress testing method, it does point out that the stress testing methods used by community banks can be less complex than those used by large banks.
Here are four stress testing methods noted by the bulletin that are commonly used by community banks:
- Transaction — Gauges the potential impact of changing economic conditions on the ability of individual borrowers to service debt, and uses this to estimate potential loan losses.
- Portfolio — Gauges the potential impact of changing economic conditions on the financial performance of borrowers, and uses this to help spot portfolio risks (both current and future).
- Enterprise-level — Gauges how different types of risk and their interrelated effects might impact the bank assuming different economic scenarios.
- Reverse — Postulates what types of events and scenarios could lead to possible adverse outcomes.
Regardless of which method is used, the OCC bulletin includes several things that are common to all effective stress tests. These include the use of “what if” questions as they relate to specific bank vulnerabilities and making reasonable determinations of the impact a market factor could have on capital and earnings. Also, the test’s results should be incorporated into the bank’s overall risk management process, the bulletin states.